TAILIEUCHUNG - Net foreign assets, interest rate policy, and macroeconomic stability

As California local agencies are becoming involved in the interest rate swap market, knowledge of the basics of pric ing swaps may assist issuers to better understand initial, mark-to-market, and termination costs associated with their swap programs. This report is intended to provide treasury managers and staff with a basic overview of swap math and related pric ing conventions. It provides information on the interest rate swap market, the swap dealer’s pricing and sales con ventions, the relevant indices needed to determine pric ing, formulas for and examples of pricing, and a review of variables that have an affect on market and termination pricing. | Net foreign assets interest rate policy and macroeconomic stability Ludger Linnemann and Andreas Schabert April 28 2003 Abstract We examine the role of foreign debt for the requirements of saddle path stability in a sticky-price small open economy model where the central bank sets the nominal interest rate and home residents are net borrowers on the international capital market. Uncovered interest rate parity does not hold as the risk of defaulting on foreign debt is increasing in its real value. Under this asset market imperfection a monetary policy strategy of letting the nominal interest rate increase strongly in response to domestic inflation which would be stabilizing with perfect asset markets entails the risk of setting the economy on an explosive path with unbounded foreign debt accumulation. However the central bank can restore macroeconomic stability if it takes current account dynamics into consideration and reduces the interest rate when indebtedness rises or alternatively if it refrains from aggressively reacting on inflation . by pegging the interest rate. JEL classification E52 E32 F41 Keywords Interest rate policy net foreign assets saddle path stability default risk sticky prices. Corresponding author. University of Cologne Department of Economics Staatswiss. Seminar D50923 Koeln Germany email linnemann@ fax 49 221 470-5077 tel 49 221 4702999. University of Cologne Department of Economics Staatswiss. Seminar D-50923 Koeln Germany email schabert@ fax 49 221 470-5077 tel 49 221 470-4532. 1 Introduction The role of current account deficits and a country s net foreign asset position for macroeconomic stability is a subject of ongoing debate. Traditionally the intertemporal optimizing view of the current account as summarized in Obstfeld and Rogoff 1996 has been interpreted as implying that foreign debt accumulation should not be seen as a macroeconomic problem since it reflects optimal consumption smoothing over .

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